Campbell Soup mini-case
(Derivatives)
Companies are exposed to different types of market risks. These risks arise because the
profitability of business operations is sensitive to fluctuations in several factors such as
commodity prices, foreign currency exchange rates, and interest rates. Market forces
determine these factors. For example, a gold mining company can control the volume
and, at least partially, the cost of gold it produces. However, its profitability depends on
the spot price of gold, a price it can neither control nor reliably forecast. This exposes a
gold mining company to commodity price risk. As another example, a U.S. equipment
manufacturer can contract to supply machinery to a foreign buyer in its local currency. If
the dollar strengthens against the local currency before the buyer makes payment, the
U.S. manufacturer loses. This exposes the U.S. manufacturer to foreign currency risk. As
still another example, a real estate financier can offer a fixed-rate mortgage to a
homebuyer. If interest rates increase, the financier may find it difficult to fund the
mortgage in a profitable manner. This exposes the real estate financier to interest rate
risk.
To lessen these market risks, companies enter into hedging transactions, or
hedges for short. Hedges are contracts that seek to insulate companies from market risks.
A hedge is similar in concept to an insurance policy, where the company enters into a
contract that ensures a certain payoff regardless of market forces. A hedge is possible
because different parties are affected in different ways by market risks. For example,
while a gold mining company is concerned with a drop in gold prices, a jewelry maker is
concerned with an increase in gold prices. This means a gold miner and a jewelry maker
are potentially interested in a contract to sell (buy) gold at a future date for a fixed price.
This is called a forward contract, and often is transacted in a commodities market.
Financial instruments such as futures, options, and swaps are commonly used as
hedges. These financial instruments are called derivative financial instruments, or simply
derivatives. A derivative is a financial instrument whose value is derived from the value
of another asset, class of assets, or economic variable such as a stock, bond, commodity
price, interest rate, or currency exchange rate. However, a derivative contracted as a
hedge can expose companies to considerable risk. This is either because it is difficult to
find a derivative that entirely hedges the risk exposure or because the parties to the
derivative contract fail to understand the potential risks from the instrument. Companies
also use derivatives to speculate. Counterparties that bear risk in a derivative contract are
called speculators.
Accounting for Derivatives
All derivatives, irrespective of their nature or purpose, are recorded at fair value on the
balance sheet. This is an important requirement that increasingly affects balance sheets of
companies, both because of the growing magnitude of derivatives and their volatile
nature. However, unlike fair value accounting for investment securities, where only assets
and not corresponding liabilities are marked to market, the accounting for derivatives
affects both sides of transactions (wherever applicable) by marking to market. This
means if a derivative is an effective hedge, the effects of changes in fair values usually
should cancel out and have a minimal effect on financial statements.
Unrealized gains and losses on fair value hedges (fixed-for-floating interest rate
swaps, futures contracts or options to hedge the fair value of a security, and the hedge of
a fixed future commitment to sell a commodity as a specified price) as well as on the
related asset or liability are recorded in income and affect current profitability. As long as
the hedge is effective, this accounting does not affect the financial statements in a
material manner as balance sheet and income statement effects are largely offsetting.
Alternatively, unrealized gains and losses arising from cash flow hedges (floating-forfixed interest rate swaps, and hedges of forecasted sales of commodities are reported as
part of other comprehensive income (e.g., as a component of stockholders’ equity and not
in current income) until the effective date of the transaction, after which they are
transferred to income and are offset by the effect of the transaction itself. For example, a
company might want to lock in the value of investment securities it owns by selling put
options. Gains and losses on the options are deferred in other comprehensive income until
the security is sold, at which time the accumulated gain or loss on the option is
transferred into income and offsets the gain or loss on the security sold. Finally,
unrealized gains and losses on speculative hedges are reported immediately income.
Objectives for Using Derivatives
The first aim in analysis of derivatives is to learn a company’s objectives for use of
derivatives. Most companies allegedly use derivatives for hedging. Still, some companies
use derivatives for trading and/or speculative purposes. Sometimes, these trading or
speculative activities arise as part of risk management services offered by the company.
For example, Enron’s Wholesale Operations and Services division offers price risk
management services for energy-related commodities such as natural gas and crude oil
with a variety of financial instruments. Also, some managers use derivatives to speculate
about movements in underlying market variables.
Identifying a company’s objectives for use of derivatives is important because
risk associated with derivatives is much higher for speculation than for hedging. In the
case of hedging, risk does not arise through strategic choice. Instead it arises from
problems with the hedging instrument, either because the hedge is imperfect or because
of unforeseen events. In the case of speculation, a company is making a strategic choice
to bear the risk of market movements. Some companies take on such risk because they
are in a position to diversify the risk (in a similar manner as an insurance company).
More often, managers speculate because of “informed hunches” about market
movements. We must realize that many companies (implicitly) speculate even when they
suggest derivatives are used for hedging. One reason for this is when a company hedges
specific exposures it does not always hedge overall company risk (see discussion below).
Risk Exposure and Effectiveness of Hedging Strategies
Once an analyst concludes a company is using derivatives for hedging, the analyst must
evaluate the underlying risks for a company, the company’s risk management strategy,
the activities of a company to hedge its risks, and the effectiveness of its hedging
operations. Unfortunately, disclosures currently mandated under SFAS 133 do not always
provide meaningful information to conduct a thorough analysis. For example, Campbell
Soup utilizes fixed-to-variable swaps to achieve a targeted percentage of variable rate
debt and takes on interest rate risk in the process. The company does not, however,
provide information to describe the method by which it arrives at this targeted
percentage, nor does it describe the level of interest-rate risk that it is undertaking in the
process. Likewise, the company does not provide information of the degree of foreign
exchange exposure and the extent to which this has been mitigated by the use of crosscurrency swaps and forward contracts.
SFAS 133 was principally designed to provide readers with current values of
derivative instruments and the effect of changes in these values on reported profitability.
Oftentimes, however, the fair market values are immaterial and the notional amounts do
not provide information necessary to evaluate the effectiveness of the company’s hedging
activities. Companies are not required to quantify, for example, the extent to which
exposures have been mitigated via hedging activities which would, if disclosed, provide
investors and creditors with a greater understanding of the effectiveness of the hedging
strategy.
Transaction-Specific versus Company-wide Risk Exposure
Companies hedge specific exposures to transactions, commitments, assets, and/or
liabilities. While hedging specific exposures usually reduces overall risk exposure of the
company to an underlying economic variable, companies rarely use derivatives with an
aim to hedge overall company-wide risk exposure. Moreover, accounting rules disallow
hedge accounting unless the hedge is specifically linked to an identifiable asset, liability,
transaction, or commitment. This raises a broader question: what is the ultimate purpose
of hedging? If the purpose of hedging is to reduce overall business risk by reducing the
sensitivity of a company’s cash flows (or net asset values) to a specific risk factor, then
does hedging individual risk exposures achieve this? It probably does, but not
necessarily.
The relevant analysis question is whether rational managers enter into derivative
contracts that increase overall company-wide risk. In some cases the answer is yes. Such
actions can arise because of the size and complexity of modern businesses and the
difficulty of achieving goal congruence across different divisions of a company. For
example, the treasury department of a company might be responsible for controlling
financing cash flows and then enter into interest rate swaps to reduce volatility of interest
payments even though these interest payments could be negatively correlated with the
company’s operating cash flows. Similarly, the American and European divisions of a
company might hedge currency risk exposures with conflicting aims because each
division is attempting to manage its specific risk exposure without considering overall
company-wide risk. An analyst must evaluate overall company-wide effects of
derivatives and be aware that hedging specific risk exposures does not necessarily ensure
hedging of company-wide risk.
Inclusion in Operating or Nonoperating Income
Another analysis issue is whether to view unrealized (and realized) gains and losses on
derivative instruments as part of operating or nonoperating income. To the extent
derivatives are hedging instruments, then unrealized and realized gains and losses should
not be included in operating income. Also, the fair value of such derivatives should be
excluded from operating assets. This classification is clear for derivative instruments that
hedge interest rate movements since the underlying exposure (usually interest expense or
interest income) is itself a nonoperating item. For hedging of other types of risks, such as
foreign currency and commodity price risks, it is less clear. That is, one classifies gains
and losses (and fair values) from derivatives as nonoperating when: (1) hedging activities
are not a central part of a company’s operations and (2) including effects of hedging in
operating income conceals the underlying volatility in operating income or cash flows.
However, when a company offers risk management services as a central part of its
operations (as many financial institutions do), we must view all speculative gains and
losses (and fair values) as part of operating income (and operating assets or liabilities).
This mini-case is designed to give you a greater understanding of the use of derivatives. I
use the Campbell Soup Company to illustrate the practical use of derivatives. Please
review the financial statements of Campbell Soup. Focus on the discussion of derivatives
in the MD&A (Market Risk Sensitivity – pages 34-36) as well as in note 18. Please
answer the following questions:
1. Describe, specifically, what Campbell Soup is trying to accomplish with its
interest rate exposure derivatives.
2. Describe, specifically, how Campbell Soup mitigates its foreign exchange risk.
3. What effects do derivatives have on its balance sheet and income statement?